Financial Resource

1031 Exchange and Tax Advantages

A 1031 Exchange or Like Kind Exchange is defined by Section 1031 of the Internal
Revenue Code. This code specifies that if an asset (usually some form of real estate such asland or a building) is sold and the proceeds of the sale are then reinvested in a like kind of an asset. As such, no gain or loss is recognized, allowing the deferment of capital gains taxes. In order to qualify certain rules must be followed. Broadly, these rules are as follows:

1.   Both the relinquished property and the replacement property must be held either for investment or for productive use in a trade or business. A personal residence cannot be exchanged.

The asset must be of like kind. Real property must be exchanged for real property. Personal property must be exchanged for personal property.
The proceeds of the sale must be invested in a like kind asset within 180 days of the sale (property must be identified within 45 days).

This is an effective way to defer paying taxes that would otherwise have been due on the first sale. For example, an investor bought a commercial property, a strip mall, for 0,000. After 6 years the investor sells the property for 0,000. This would result in a gain of ,000 and the investor would have to pay capital gains tax on this amount.

However if the investor invests the 0,000 in another commercial real estate (of like kind – does not necessarily have to be a strip mall) then the investor does not have to pay any taxes now, i.e., the investor defers the taxes until a later date.

A 1031 Exchange is similar to a traditional IRA or 401K Retirement Plan. When someone sells assets in tax-deferred retirement plans, the capital gains that would otherwise be taxable are deferred until they begin to cash out of the retirement plan. The same principal holds true for tax-deferred exchanges or real estate investments. As long as the money continues to be re-invested in other real estate, the capital gains taxes can be deferred. Unlike the afore-mentioned retirement accounts, rental income on real estate investments will continue to be taxed as net income is realized.

Once an investor has decided to pursue a 1031 Exchange, the process is fairly straightforward and will be carefully facilitated by a Qualified Intermediary. It is suggested that you contact a Qualified Intermediary as soon as the exchange decision has been made.

Here is a typical timeline involving an exchange, presented in the traditional order of occurrence.

1.   Investor decides to sell investment property and do an exchange. Investor contacts a Qualified Intermediary.

2.   Investment property is put on the market.

3.   Offer to purchase investment property is accepted.

4.   Escrow for the sale is opened and preliminary title report produced.

5.   The Qualified Intermediary sends required exchange documents to escrow closer for signing at property closing.

6.   Escrow closes.

7.   Within the first 45 days after the close of escrow on the sale of the relinquished property, investor identifies replacement property as required by law.

Within 180 days after the close of escrow on the sale of the relinquished property, investor closes on replacement property that was identified by them. The exchange is completed.

Frequently the most difficult component of a 1031 Exchange is identifying replacement property within the first 45 days following the sale of the relinquished property. The IRS is very strict in not allowing extensions. The only way to extend your 45 days is on the front end, and that is done by carefully thinking about your replacement property alternatives before you close on the sale of your relinquished property.

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